Before you jump into any investment, it’s important to determine if a company can maintain its liquidity and remain solvent over time. Liquidity and solvency ratios work together, but they shouldn’t be used interchangeably since their concepts are quite different.
Solvency and liquidity ratios are important tools in determining the financial well-being of a business that ultimately leads to a company’s financial strategies in the short term and long term.
Liquidity is the ability for a company to pay off its short-term debt obligations, and its ratios measure its ability to do so as bills come due, usually within a year.
Solvency is concerned with a company’s long-term financial stance. Solvency ratios are tests designed to look at a company as it relates to its peers’ level of long-term debt.
These ratios should be used to understand relationships among debt, assets and profits. Here is your guide to understanding these metrics and how they’re used to evaluate the financial stability of a company:
— Interpreting liquidity and solvency ratios.
— Drawing comparisons between similar businesses.
— Understanding how companies respond to liquidity and solvency issues.
Interpreting Liquidity and Solvency Ratios
Several liquidity ratios work together to paint a picture of a business’s financial stability.
Current ratio: This ratio, which is also called the “working capital ratio,” is calculated by dividing current assets by current liabilities. In accounting, current assets are assets that are expected to be converted to cash within a year of appearing on a company’s balance sheet. A company’s current liabilities are all of the business’s obligations due within a year or within a normal operating cycle.
If the working capital ratio is 1 or more, this means the current assets equal or exceed the current liabilities, and the company can satisfy short-term obligations.
Quick ratio: The quick ratio, otherwise known as the “acid-test ratio,” is another liquidity metric measuring the ability of a company to pay its short-term financial obligations concerned with its most liquid assets, or assets that can quickly be converted into cash. This ratio is considered more stringent than the current ratio.
The calculation is current assets minus inventories divided by current liabilities. If liquid assets exceed current liabilities, the company can pay short-term financial obligations within a year. This ratio shows the cash value of liquid assets for every dollar of current liabilities.
Cash ratio: This ratio shows what position the company is in paying its debts by taking a company’s current, highly liquid assets like cash and cash equivalents and dividing it by its current liabilities.
Solvency dissects the relationship among debt, equity and assets to understand the stability of a company’s capital structure. The following solvency ratios measure the organization’s ability to pay off its long-term debt:
Debt-to-assets: This calculation determines how much of a company’s assets are financed by debt and is determined by dividing total debt by total assets.
Debt-to-equity: This ratio, known as D/E, measures the amount of debt a company has relative to the equity in a business and is found by dividing total debt by total equity.
Long-term debt to equity: This ratio measures the amount of long-term debt a business has in comparison with its total equity. This ratio is important because many companies make financial decisions on whether to use long-term debt or equity to fund long-term business operations. This ratio is determined by subtracting total liabilities from total debt and dividing by total equity.
Total debt to total capital ratio: This is found by calculating both current and long-term debt and dividing that by total capital, composed of total debt and equity.
Drawing Comparisons Between Similar Businesses
One ratio alone may not tell the story of the financial health of a company. These ratios should be reviewed with comparable businesses to best determine the financial well-being of a company
Always compare a company’s ratios with other companies in the same industry, says John Grivetti, partner in the advisory services group at Crowe, an accounting firm based in Chicago.
Grivetti urges investors to “start looking at the makeup of the balances used to calculate the ratios, more specifically, determine the makeup of the current assets; are they mostly made up of cash or inventory?”
A business should hold assets worth enough to pay both short-term and long-term obligations. Cash is more liquid than inventory since it may take a while to sell off.
Companies constantly evaluate how quickly they turn the inventory to cash.
“If you’re comparing two companies that have the same current ratio and one company’s current assets are made up of mostly cash, while the others are made up of mostly inventory, the company with cash is more likely to be able to pay off its short-term obligations, since inventory will take longer to sell,” Grivetti says.
Timing is important, Grivetti stresses. “If inventory makes a large portion of current assets, a company has to determine, ‘Can we turn over that inventory to meet short-term debt obligations?'” he says.
These ratios can point to issues within a company, such that it can’t meet immediate or long-term obligations or it’s not generating enough cash flow to pay debt agreements. Liquidity carries lower risk because short-term issues can be caught early in the process, while solvency carries long-term risk.
Experts recommend investors study companies’ trending data and see how ratios have changed over time. These ratios are designed to focus on a business’s operating capacity as it relates to its peers.
“When I go look at a company to invest in, I look at the industry itself and review their liquidity and solvency to determine which is the most financially solvent,” says James Biagi, associate teaching professor at Stevens Institute of Technology in Hoboken, New Jersey.
If the liquidity ratio is trending down, there may be an issue. Losing liquidity means a business is reducing its ability to pay bills over the short term.
When solvency ratios are going up, the business could be spending too much money. If its debt is trending upward, this means the business may not be making enough money to pay its long-term bills. This is also a concern and can open the company to long-term risks.
[Read: How to Invest in VIX ETFs.]
Understanding How Companies Respond to Liquidity and Solvency Issues
In today’s economic environment, companies are experiencing solvency concerns, as sales are declining while businesses have been closed due to the pandemic. Most companies are having issues with reduced net income. Since liabilities and debt obligations are not significantly changing, solvency ratios are declining across the board in many industries.
To address liquidity or solvency concerns, companies should have a plan for improving their profitability, which can include actions like cutting costs, reducing employees or changing the operating environment.
For example, United Airlines (ticker: UAL) has taken steps to “aggressively and proactively” cut costs by suspending raises, freezing hiring and issuing massive furloughs and layoffs of up to 36,000 employees.
To remedy liquidity concerns, look to see if a company is speeding up the monetization of current assets beyond cash or negotiating short-term liabilities to get better terms from their lenders to pay them longer.
“Understanding a company’s solvency position will shed light on the potential strategic alternatives based on the company’s ability to satisfy its fixed-charge obligations,” says Philip Kaestle, senior director at SierraConstellation Partners, an operational advisory services firm in Seattle.
If a company realizes it has liquidity issues, there are certain actions it can take. Experts note solutions include selling inventory at a reduced price to get cash quickly, seeking short-term financing, or restructuring debt to address solvency issues.
“Companies with relatively low leverage are well-positioned to raise additional capital or refinance their existing debt,” Kaestle says.
He adds, “Once leverage reaches a certain point, these options are no longer viable, and the company may need to consider a sale or a balance sheet restructuring to address its solvency issues.”
Understand the financial health of a business over time as well as how a business compares with its peers.
These ratios not only help companies manage their business effectively, but they can also assist investors to make sound decisions when examining businesses within the same industry.
More from U.S. News